With inflation and interest rates on the rise, investors are paying more attention than ever to intrinsic value, rather than just revenue growth and momentum that we've seen over the past few years.
Dyed-in-the-wool value investors generally point to free cash flow as the "holy grail" metric by which to value a stock. That's because a company's cash capital expenditures and working capital investments often exceed non-cash depreciation, either because of growth or merely inflation. When that happens, the amount of cash left over for shareholders after these investments may be lower than what headline earnings would suggest.
Yet while free cash flow may be the conservative metric to use in, say, a manufacturing business, in the world of software, free cash flow can be really, really misleading.
In fact, free cash flow often looks better than headline earnings in software, and deceptively so. Unsurprisingly, many technology CEOs often point to their free cash flow generation, when in fact the real earnings going to shareholders is far lower... or even negative.
Here's an example of what I'm talking about, and it's something every investor in the software space needs to recognize.
25% free cash flow margin? Not really.
Let's take cybersecurity company Palo Alto Networks (PANW 1.37%) as an example.
First, Palo Alto is a great cybersecurity company. Management has done an excellent job of transitioning its legacy on-premises firewall business to more modern cloud and software-based threat detection solutions. The company has managed to continue strong revenue growth, even matching the newest disruptors in this fast-evolving space.
While I applaud Palo Alto for its product execution, investors should probably ignore the high adjusted (non-GAAP) free cash flow margin that management touts in company presentations.
Last quarter, Palo Alto's adjusted free cash flow was $351 million on $1.39 billion in revenue, good for a 25.3% free cash flow margin. Great, right? Well, investors have to square that with the company's GAAP net loss of $73.2 million. That's a $425 million discrepancy, and it makes a big difference when trying to value the company. So which metric to use?
Unfortunately for investors, they should probably stock with GAAP net losses on this one, for two big reasons.
Value killer No.1: Stock-based compensation
Palo Alto takes the relatively straightforward "operating cash flow minus capital expenditures" equation to calculate free cash flow. Software companies don't have to spend much on buildings or manufacturing plants, so their capex is usually very low.
However, operating cash flow commits two big distortions in software, with the first being stock-based compensation.
Virtually all companies compensate their employees with stock to some extent. However, in the software world, stock-based compensation tends to be very high, especially at high-growth companies that would rather conserve their cash. In Palo Alto's case, the company paid out a whopping $247.3 million in stock to employees last quarter alone, and roughly $1 billion over the past 12-month period.
While stock-based compensation doesn't cost the company in terms of cash, it does dilute existing shareholders -- in other words, you. Palo Alto is a $50 billion market cap company, so the trailing-12-month stock comp amounts to a 2% dilution on an annual basis.
Warren Buffett has had a word or two in the past for management teams that tout "adjusted" earnings and free cash flow, while omitting stock-based compensation. In his 2015 letter to Berkshire Hathaway (BRK.A 0.64%) (BRK.B 0.54%) shareholders, he wrote:
[I]t has become common for managers to tell their owners to ignore certain expense items that are all too real. "Stock-based compensation" is the most egregious example. The very name says it all: "compensation." If compensation isn't an expense, what is it? And if real and recurring expenses don't belong in the calculation of earnings, where in the world do they belong?
Image source: Getty Images.
Value killer No.2: Deferred revenue
The second way free cash flow distorts real owners' earnings at software companies is deferred revenue.
Software businesses that operate on a subscription basis often collect a contract's worth of cash up front, whether it be a year, two years, or whatever the term is. However, when it does, the company's deferred revenue and cash holdings go up, and the change in deferred revenue shows up in operating cash flow. Deferred revenue is revenue that has been collected, but it won't be recognized right away, but rather ratably over the life of the contract.
Last quarter, Palo Alto recorded a strong increase of $410.2 million in deferred revenue. To be fair, Palo Alto also deducted an item called "deferred contract costs," which are likely to up-front investments made at the beginning of a contract, but that cost was only $105.9 million. Subtracting that, the "net" deferred revenue increase was still more than $300 million.
No doubt, there are positives to this. Increases in deferred revenue show Palo Alto is signing up new customers or up-selling current ones; however, should it really be counted as part of free cash flow?
Deferred revenue means the company is paid before it has actually delivered services. Essentially, it's similar to taking out a cash loan that you have to pay back with infrastructure, sales, and support later on -- although there should be some cash left over as profit. Still, you wouldn't expect a company to take out a loan that has to be paid back in the future and then call it "cash flow," would you?
Even worse, sometimes companies offer big discounts in exchange for up-front payments. Therefore, without knowing the length of the term or the discount, it's difficult to know how profitable all that deferred "revenue" might be.
No doubt, deferred revenue is an advantage for growth companies. It shows the company is signing up new clients, and the available cash can be used for expansion or acquisitions without taking on debt. But in terms of having that cash go to the shareholders of the company? It's just not the case.
Be careful in the software world
We've just gone through a period in which investors mostly priced software stocks off of revenues and/or other various "adjusted" profitability metrics. But with interest rates on the rise, these shortcuts may receive renewed scrutiny, as investors are now in a "show me" state, in which they want to see profitability... real profitability.
So if you hear a software CEO talk about free cash flow as if it's all the money left over for shareholders, remember to look up the company's stock-based compensation and deferred revenue on the cash flow statement. Palo Alto is just one example, but most high-growth software companies usually point to some kind of non-GAAP adjusted profit metric these days.
Meanwhile, don't forget to look at boring old GAAP net income (or losses), which should provide a much more accurate picture of actual profitability. You may come to realize the high-growth software company in your portfolio isn't as attractive as you'd first thought.
